This answer is incorrect because in a loan with a compensating balance the effective interest rate is higher than the nominal interest rate. See the correct answer for a complete explanation.
This answer fails to take into consideration the fact that the company ordinarily maintains a balance of $25,000 in its checking account for transaction purposes. Thus, the amount of the loan proceeds that will be added to the checking account needs to be only $25,000, not the full $50,000 required.
In a loan with a compensating balance, the borrower pays interest on the full amount of the loan but does not receive the use of the full amount of the loan in cash, since they are required to leave some of it on deposit as a compensating balance. In this case, since they already maintain a $25,000 balance at the bank, they will need to add only $25,000 from the loan proceeds to meet the compensating balance requirement. Therefore, the company will have the use of $225,000 of the loan. However, they will pay interest of 6% on the full $250,000 loan amount. $250,000 × .06 equals $15,000 of annual interest expense. However, this interest expense is reduced by the interest that will be earned on the money that was deposited to meet the compensating balance requirement. The incremental amount of the deposit increase is not the full $50,000 of the required compensating balance, but only the $25,000 that the company needed to add to what was already in the bank. Interest earned on $25,000 at 2% per annum equals $500 interest received. This interest received offsets the larger interest cost, making a net interest expense of $14,500. The effective interest rate on the loan is thus $14,500 ÷ the $225,000 received, or 6.44%.
This is $15,000 interest per year on the loan divided by the net usable loan proceeds of $225,000. This answer fails to take into account the interest that will be earned on the money deposited to meet the compensating balance requirement. See the correct answer for a complete explanation.
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